By Leika Kihara

TOKYO (Reuters) – The Bank of Japan (BOJ) is expected to raise interest rates again this year, with borrowing costs projected to reach neutral levels by the end of 2027, according to Nada Choueiri, a senior official at the International Monetary Fund (IMF).

The IMF estimates Japan’s neutral rate to be between 1% and 2%, with a mid-point of 1.5%. Japan’s economy is forecasted to grow by 1.1% this year, boosted by rising wages that support consumption and help meet the BOJ’s 2% inflation target.

Choueiri stated, “Our baseline remains a story where we see increasingly strengthened domestic demand underpinned by continued recovery in real wage growth.” She added that if the economy improves as expected, the BOJ is likely to gradually increase policy rates.

Following the conclusion of its extensive monetary stimulus last year, the BOJ raised short-term interest rates to 0.5% from 0.25% in January, believing Japan was nearing sustainable achievement of its 2% inflation objective.

BOJ Governor Kazuo Ueda has expressed commitment to continue raising rates to neutral levels, estimated between 1% and 2.5%. Choueiri endorsed the BOJ’s approach, advocating for gradual and flexible rate increases to foster domestic demand.

She anticipates policy rates exceeding 0.5% by the end of 2023, reaching the neutral rate by the end of 2027. However, risks to Japan’s economy remain, with geopolitical tensions potentially dampening global demand and impacting companies reliant on international supply chains.

On the fiscal side, the IMF advises Japan to cut energy subsidies and direct spending toward initiatives that promote long-term growth. Choueiri emphasized optimizing spending for better growth impact, especially in areas that enhance private investment efficiency.

She highlighted the importance of devising a clear plan to reduce the deficit and lower the debt ratio in the coming years. Prime Minister Shigeru Ishiba’s coalition faces pressure to increase spending and modify tax structures, which could compromise Japan’s financial standing.

Expected interest rate hikes and a gradual reduction in bond purchases by the BOJ are likely to raise bond yields and escalate the cost of servicing Japan’s significant debt.

Currently, the risk of a sudden spike in bond yields is minimal due to the BOJ’s deliberate approach to rate hikes and quantitative tightening. However, Choueiri cautioned that the government must act swiftly to initiate fiscal reforms and address Japan’s high debt-to-GDP ratio.

“Now is the time to prepare a fiscal consolidation plan and begin implementing it gradually to avoid abrupt adjustments in the future,” she advised.